2 Stocks Private Equity Firms Can Buy

Private equity firms have a lot of idle cash on their hands, which they need to invest in the coming year, according to a recent research by Barron's. The research identified Guess (NYSE:GES), Terex (NYSE:TEX), Charles River Laboratories (NYSE:CRL) and Big Lots (NYSE:BIG) as ideal candidates for private equity buyouts. This article mainly concerns Guess, an apparel and accessories brand, and Big Lots, a general merchandise retailer.

PE firms raise funds and then invest them in companies through leveraged buyouts, venture capital etc. The firms' earnings come from fees for managing investments, and a share of the profits earned by the investments. According to an article, in the past decade, private equity firms have made companies they invest in take more debt, and pay out special dividends, so that the firms can get back their initial investment as well as avoid the risk of a loss if the company does not provide enough returns by improving. These dividends amounted to about $70 billion between 2003-07.

According to Barron's, private equity firms look for the following characteristics in potential candidates for a buyout:

The company is valued between $1-10 billion.

There are low barriers to acquiring the company e.g. regulations.

Enough free cash flow that the company can spend on dividends and share repurchases. Annual cash flow that is 5% or more of the market cap.

A low EV/EBITDA, preferably below 10x.

A lot of investment is expected from private equity firms, as the record funds raised in 2007 have to be used sometime soon, or the firms risk losing potential management fees, as well as having to return the money raised from investors. According to research firms Preqin and Cambridge Associates, private equity firms have $300 billion and $350 billion respectively to spend. According to Preqin, private equity deals in Q32012 have a total value of $71.6 billion, which is an increase of 9% in the value of the deals as compared to last quarter. 20 deals were valued above $1 billion in Q3. North America is the most active area for buyouts (two-thirds of the global buyouts) with the values of deals rising since Q22012.

In our previous article on Guess, we had recommended buying Guess based on its cheap valuations relative to its peers, and its double digit earning growth rate. The company relies on North America for 49% of its revenues. Guess' profit margin (trailing 12 months) of 8.8% is well above that of Gap (NYSE:GPS), whose same store sales have risen sharply this year, beating analyst estimates. GPS' profit margin is almost 6%. The company has an impressive dividend yield of 3.2%, or $0.08 annual dividend per share. Cash per share for the company is $3.31, while the free cash flow yield is 6.3%. The market cap for GES is $2.12 billion, with negligible debt. Levered free cash flow forms 7.6% of the market cap at current levels.

GES trades at an EV/EBITDA of 4.47x as compared to peers, like GPS' 8x, Abercrombie and Fitch's (NYSE:ANF) 5x and Ralph Lauren's (NYSE:RL) 10x. For us, the company is a good buy even if the buyout does not take place. Currently European exposure has hurt the company (37% of last year revenues), but its Asian business is growing.

In our last article on Big Lots, we had advised against investing in BIG, unless its Canadian operations turn profitable, and the remodeling of its stores make them more attractive to customers. The company faces competition from the likes of Target (NYSE:TGT) and had cut its latest earnings guidance.

However, the free cash flow yield (trailing 12 months) of 8.4% makes it attractive for private equity firms. The company guided to a cash flow of $125 million (6.7% of market cap), down from $190 million. The company has repurchased 6% of its outstanding shares in Q2 FY2012. The market cap is $1.79 billion at the current share price.

In terms of EV/EBITDA, it trades at a multiple of almost 5x, which is at a significant discount when compared to TGT's 7.7x and Dollar General's (NYSE:DG) 10x, though these peers have higher profit margins.

With a short ratio of 4.3 days and 8.4% of the float short, some investors might consider it a little over sold. According to Barron's, the shares of BIG had gone up to $40 from $32 in 2011, on the news of an expected buyout from Bain Capital and TPG capital, two of the largest private equity firms. The shares are currently trading at $30.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Retail Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.